[Investment Quarterly] Is a New Market Regime on the Horizon?

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“When the weather changes, nobody believes the laws of physics have changed. Similarly, I don’t believe that when the stock market goes into terrible gyrations its rules have changed.”  – Benoit Mandelbrot (1924-2010), Polish-American Mathematician

The equity market ended a rollercoaster first quarter with a small loss (-0.76%) for the S&P 500, snapping a nine-quarter winning streak. The first quarter featured two of the three largest single-point declines on record for the S&P 500 (February 5th and 8th), and a general increase in volatility across most financial markets. After an unusually calm 2017, it was reasonable to expect the markets to experience higher volatility in 2018 and, to date, they haven’t disappointed.
The big question is: What, if anything, has changed, and does it signal a new market regime?

Over the past three months, the narrative surrounding the market has changed to today’s more cautious stance. But before we dig further into what’s changed, let’s go back to January 26th. The S&P 500 closed at a record high level on that day, up 7.5% for the year, and investors were in a state of near bliss. Equity prices were higher and volatility was abnormally low. The markets were buoyed by talk of global synchronization and the anticipated positive economic impact from tax reform.

Then came the sharp, early February declines, which were caused by fears of more aggressive-than-anticipated U.S. Federal Reserve (Fed) policy and higher bond yields that stemmed from a combination of accelerating wage growth and increased federal budget deficit worries in a full-employment economy. By the end of the quarter, stocks were ebbing and flowing on news and rhetoric regarding tariffs and the possibility of a trade war, specifically with China.

Let’s take a look at a few of these concerns:

  • Higher central bank rates. On March 21st, the Fed increased the target federal funds rate for the sixth time since 2015 and indicated another two or three quarter-point increases in calendar-year 2018, and a terminal rate of 3.5% to 3.75% in 2020. While rates have increased, by historical standards monetary policy still remains accommodative. Despite the six increases, the target fed funds rate remains below inflation—a stance that remains stimulative to the economy. Even at the projected terminal rate of 3.625%, fed funds would be at a narrower spread to projected inflation than what is historically considered “neutral.” It’s also worth noting that a new Fed chair was appointed with a different background and communication style that market participants need to get comfortable and familiar with.
  • Higher bond yields. Bond yields rose and the yield curve flattened slightly during the first quarter, continuing a trend in place since the Fed first increased rates for this cycle in December 2015. While higher yields do provide some competition for investment capital, yields are still low relative to history and provide little return relative to inflation. Investors accumulating and saving for long-term needs (e.g., retirement) should and will continue to allocate to bonds for risk management and liquidity purposes; but, in our opinion, yields are not at a point to encourage a substantial asset-allocation shift. Going forward, we expect further increases in bond yields to be muted by the well-contained inflation environment and the fact that other developed-market yields (such as those of Germany and Japan) remain lower than U.S. yields. Until, and unless, those conditions change, they will help provide somewhat of a “soft ceiling” on domestic bond yields.
  • Tariffs. Tariffs and fears of a trade war have dominated market news in recent weeks. The Trump Administration has targeted China, and China has responded, increasing fears of further escalation. The three most-cited examples of U.S. tariffs are the Tariff of Abominations (1828), the Smoot-Hawley Act of 1930 and the steel tariffs of 2002, the last of which are probably most analogous. Imposing tariffs has generally been considered net negative based on resulting job losses, a weaker dollar, and higher prices and shortages of certain products. Global trade matters to the large public companies that make up the S&P 500. They derive roughly 43% of their revenues from overseas and need access to those markets to drive the type of double-digit growth the market appears to be pricing in. Tax cuts will help them meet expectations this year but going forward will likely have less of an impact in terms of earnings growth.

Returning to the question of whether or not we have entered a new market regime, we would say that the answer is “yes,” although not necessarily due to macroeconomic developments. Certainly the twin factors of interest rates and international trade bear close monitoring. If inflation accelerates from its low levels of recent years, leading to a more aggressive Fed, equity valuations could be pressured. Political risk in the form of a trade war would also likely have ramifications for stocks.

However, the economic backdrop still appears relatively benign for equities markets: Fed policy is still accommodative; inflation remains muted; bond yields are relatively low; the economy is growing at a steady—if unspectacular—rate; and tax reform should be positive for earnings, which are expected to grow at a healthy pace in 2018.

What might be of greater concern is the political risk. President Trump has a different form and way of communication, much more direct and off-the-cuff, delivered in real time via his Twitter account. That, coupled with what may be stretched valuations after nine years of a bull market, and heightened investor anxiety after this year’s volatility, lead us to believe that investors will be more
cautious going forward and more discerning. It also appears that after a period of very low market volatility (2017), the environment is reverting to a more normal level of price swings.

A good example of this new environment is the recent weakness and volatility in the tech sector, which previously had seemed almost immune to concerns over valuations or the economic backdrop. Investors are now reevaluating this sector in light of Facebook’s recent disclosures (that the company allowed a political consulting firm to collect users’ personal information without consent) and President Trump’s comments on Amazon (including accusations that the company has fallen short on paying taxes and that it’s undercutting the U.S. Postal Service).
While these are top-of-mind concerns, we still believe the conditions for an extreme negative market event are currently absent.

Bill Hornbarger
Chief Investment Officer

Market Recap

  • While 2017’s unprecedented rally continued into the beginning of 2018, volatility returned and equity markets began to stumble—at first in early February, driven by U.S. wage growth and deficit worries, and then in the latter part of the quarter on global tariff/trade war concerns.
  • The tariff concerns were anemic for both U.S. and international equities once the administration announced the initial plans; however, the specific tariffs continue to evolve, so it has become difficult to forecast any specific impact.
    Fortunately, emerging markets and U.S. growth stocks were able to withstand quarter-end weakness and finish in positive territory given their strength early in the quarter.
  • Despite the recent increase in volatility and seemingly high valuations, at this point there haven’t been any large enough changes in the fundamentals of the economy or corporate earnings to warrant a more negative outlook on the market.
    Performance in the fixed-income markets was decidedly negative overall in the first quarter as the impact from rising interest rates and widening credit spreads took their toll.
  • The shape of the yield curve remained at its pre-Global Financial Crisis levels; however, credit spreads began to widen for the first time in nearly two years—although only slightly.
  • Most signs of economic health remained strong during the first quarter as employment remained healthy and business leaders’ outlook for the economy continued to be optimistic.
  • As expected, the Fed voted to raise the fed funds rate in March to a target range of 1.50%-1.75%, noting that the “economic outlook has strengthened in recent months” while highlighting strong job gains and low unemployment rates; however, the Fed did note moderation in consumer spending and business investment.
  • Policymakers maintained their plans for a total of three rate hikes for 2018 but indicated that there could be an additional increase in 2019, a slightly more hawkish tone than the market expected.
  • As for tariffs, the Fed noted that the topic was discussed during its committee meeting but there’s no thought that changes in trade policy would have any effect on its current outlook.
  • Outside of the U.S., the European Central Bank still seems to be in no rush to raise rates as it continues to revise down inflation forecasts, despite raising growth forecasts. In the U.K., similar to the U.S., wage growth is creating cause for optimism. However, the U.K.’s main economic risks are the early signs of weakness in the housing market and the potential impact on consumer confidence.

Leading Economic Indicators

 

  • The leading economic indicator (LEI) index increased in both January and February (March results won’t be released until the end of April). Additionally, February marks the fifth-consecutive month of LEI index increases.
  • For February in particular, despite a sharp downturn in the markets during that month, the LEI index’s growth was fueled by all components, except for building permits and stock prices.
  • The largest positive contributors to LEI included average weekly manufacturing hours, the ISM new orders index and the decline in average weekly initial unemployment claims.

Employment

 

  • The employment picture in the U.S. continues to be healthy as the unemployment rate has settled in at 4.1% over the past few months and the weekly initial jobless claims hit a 45-year low.
  • Wage growth appeared to accelerate early in the quarter, from 2.5% to 2.9% on a year-over-year basis, a fairly substantial move in just over one month.
  • Fortunately, it seems that the acceleration was short-lived as the wage growth fell down to 2.6% the following month, closer to its more recent normal level versus the recent past.

Business Outlook

 

  • Overall confidence by businesses continues to be optimistic when reviewing recent readings from the National Federation of Independent Business (NFIB), the Institute of Supply Management (ISM) and the Conference Board’s CEO Confidence Survey.
  • For the NFIB, the percentage of respondents with positions not able to be filled, that are planning on hiring in the future, and/or that are raising compensation, continues to be near all-time highs.
  • The ISM Manufacturing Index remains near its highest level since the Global Financial Crisis, and the CEO Confidence Survey, which measures the responses of 100 CEOs from various industries, is at its highest level in 15 years.

Equity Performance

 

 

  • Similar to the previous year, the beginning of the quarter started off with a bang; however, heading into February, equity markets began to stumble.
  • Even though many highlight trade rhetoric for the initial selloff, much of it was actually driven by the wage growth acceleration mentioned earlier, as well as concerns for higher deficit spending, causing investors to be concerned that U.S. interest rates would rise faster than the economy could handle.
  • Driven by continued strength in corporate earnings, equities were able to recover from much of the early February weakness by month end. As the quarter ended, stocks faced new pressures over trade concerns.
  • The discussions of tariffs were not only anemic for the U.S.; international stocks (both developed and emerging) were also rocked in the latter part of the quarter when the administration announced tariffs on steel and aluminum imports, as well as $60 billion worth of Chinese imports.
  • Fortunately, given their strength early in the quarter, EM and growth stocks were able to withstand the onslaught at the end and finish above water.
  • Value stocks were the weakest during the quarter, driven by large declines in telecom, real estate and energy.
  • The sectors recording the quarter’s best performance included technology and consumer discretionary.

Trailing 12-Month and P/E Ratio

 

  • With the drop in equities at the end of the quarter along with steady growth in earnings, the S&P 500 price/earnings (P/E) ratio dropped on a quarter-to-quarter basis for the first time since the end of 2016.
  • Even with this recent drop, valuations haven’t really budged much over the past nine quarters using either trailing 12-month earnings or Wall Street’s consensus estimates.
  • Despite the recent increase in volatility, outside any political noise, at this point there haven’t been any large enough changes in economic fundamentals or corporate earnings to warrant a more negative market outlook.

Valuation Blend

 

  • Using our four-factor blend, valuation activity was relatively mixed across all of the segments.
    The largest valuation changes, relative to their historical averages, were the declines in value equities, which included all market-cap sizes.
  • Even though large value equities dropped, given the overall strength in large-cap companies prior to this past quarter, it still remains one of the richest parts of the market, along with large-, mid- and small-cap growth.
  • U.S. small-cap value continues to sit with developed international equities as the cheapest relative to other equity asset classes.

Fixed–Income Sectors

 

  • In the U.S. Treasury market, although yield curve spreads continued to compress, the losses were larger on the longer end of the yield curve.
  • While inflation is edging up, inflation expectations have not risen enough to support the prices of Treasury Inflation Protected Securities, preventing them from recording positive returns.
  • Even though credit was generally weak, high-yield outperformed investment-grade as its credit spreads held up better, offsetting much of the impact of higher interest rates.

Yield Curve 

 

  • The shape of the yield curve remained at its pre-Global Financial Crisis levels, with the spreads between short- and intermediate-term rates and short- and long-term rates both sitting below 100 basis points.

Corporate Spreads

 

  • In the credit markets, after declining in January, credit spreads of both investment-grade and high-yield debt widened on a quarter-to-quarter period for the first time since early 2016.
  • Credit spreads remain near decade lows, and well below long-term averages.

Please note, these materials were prepared for informational purposes only and do not take into consideration your individual circumstances. This is not an offer to purchase/sell securities. Past performance is not indicative of future returns. Alternative investments possess features and risks distinct to the individual investment vehicle, and any decision to invest in such vehicles should be made based on your individual circumstances in consultation with appropriate financial professionals.